Stock Analysis

Here's Why DXC Technology (NYSE:DXC) Has A Meaningful Debt Burden

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NYSE:DXC
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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, DXC Technology Company (NYSE:DXC) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

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What Is DXC Technology's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 DXC Technology had debt of US$8.65b, up from US$7.98b in one year. However, it does have US$3.08b in cash offsetting this, leading to net debt of about US$5.58b.

debt-equity-history-analysis
NYSE:DXC Debt to Equity History December 6th 2020

How Healthy Is DXC Technology's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that DXC Technology had liabilities of US$8.66b due within 12 months and liabilities of US$12.3b due beyond that. Offsetting these obligations, it had cash of US$3.08b as well as receivables valued at US$4.19b due within 12 months. So its liabilities total US$13.6b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$6.35b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, DXC Technology would probably need a major re-capitalization if its creditors were to demand repayment.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

DXC Technology has net debt worth 2.0 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.6 times the interest expense. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. Importantly, DXC Technology's EBIT fell a jaw-dropping 51% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine DXC Technology's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, DXC Technology produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

To be frank both DXC Technology's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that DXC Technology's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that DXC Technology is showing 1 warning sign in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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What are the risks and opportunities for DXC Technology?

DXC Technology Company, together with its subsidiaries, provides information technology services and solutions primarily in North America, Europe, Asia, and Australia.

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Rewards

  • Trading at 64.7% below our estimate of its fair value

  • Earnings are forecast to grow 5.56% per year

  • Became profitable this year

Risks

  • Significant insider selling over the past 3 months

  • Has a high level of debt

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